hongkongen
Factor investing debates: Are fees the most important variable in product selection?

Factor investing debates: Are fees the most important variable in product selection?

14-02-2020 | Insight

To choose a product, investors tend to rely on a few easy-to-grasp variables, like recent performance and, increasingly, fees. In the case of factor investing, the explosion in the number of smart beta products has clearly put the spotlight on this second aspect. Yet focusing too much on fees can be counterproductive.

  • Yann Morell Y Alcover
    Yann
    Morell Y Alcover
    Investment Writer

Speed read

  • Rise of smart beta ETFs shows how important fees have become
  • But fee reductions can easily be cancelled by other elements
  • Active management can prove worth the higher fees

The widespread adoption of factor investing has been largely driven by the success of generic products, often labeled ‘smart beta’ and marketed as index funds of exchange-traded funds (ETFs). A key reason behind this success is low fees. Over the past decade, investors have increased their scrutiny on this aspect, as they became more aware of the impact fees have on their long-term returns.

Smart beta did not escape unscathed. Morningstar’s 2019 US fund fee study noted that the ‘fee war’ that has been raging for years among capitalization-weighted index funds has now spread into other segments, including smart beta. The study also said that while smart beta ETFs’ fees remain higher than those of traditional index funds, they are now much lower than those of active funds.

The virtues of index-based, low-expense investment products have been abundantly publicized by prominent voices of the investment community – and reported in influential scientific publications.1 As Princeton University professor and best-selling author Burton Malkiel put it in a 2017 interview with Robeco, investors should “control the things [they] can, and one of those things is costs.”

Fee scrutiny has become so intense that ETFs are now commonly regarded as an attractive, low-cost alternative to actively managed mutual funds, despite the lack of empirical evidence to support this claim. Actually, recent Robeco research suggests the average ETF investor is, in fact, not necessarily better off. This is also the case for those investing in factor ETFs.2

Surely, while this push towards more cost-efficient factor investing products has enabled considerable savings for investors, in many cases it has also been to the detriment of the quality of the solution. This is especially true for factor investing. Indeed, while generic products on smart beta indices have merits, including their high transparency and low fees, they also come with serious drawbacks.

These drawbacks have been highlighted in numerous empirical studies.3 For instance, many of these products provide only limited exposure to a targeted factor, or combination of factors, as well as unwanted negative exposures to other proven factors. This is because individual factors can have negative exposures to other proven factors, and generic factor strategies tend to overlook this issue.

Smart beta products also often use inefficient index construction processes that can result in unnecessary turnover, high concentration in some countries, sectors or industries, or excessive exposure to large-capitalization securities. In addition, they are prone to overcrowding and arbitrage, partly due to their naive trading rules, where transactions are concentrated on just a handful of rebalancing dates every year, and entail a complete lack of capacity control.

Finally, another important aspect is that the methodology of smart beta strategies is set in stone, which means that they cannot be adjusted to take into account incoming research insights, nor the potentially changing needs and priorities of clients. Yet what was state -of the art a decade ago is usually no longer state of the art today.

Gauging fees, risks and real factor exposure

Ultimately, the debate concerning the importance of fees in the product-selection process is not so much about fee levels in absolute terms, but rather about which solutions provide the highest long-term net returns. In other words, which solutions provide the most efficient factor exposure and the best risk management per basis point of fee. Unfortunately, measuring this is easier said than done.

Even when tapping very similar well-known sources of returns, factor portfolios can be constructed in many ways. For example, a value strategy can be based on the book-to-market ratio, but also on the earnings-to-price ratio or the free cash-flow-to-price ratio. Similarly, buy-and-sell rules of a strategy can also be defined in numerous ways.

These examples show that implementing factor investing is definitely not a binary decision. Once they have decided to go for it, investors inevitably have to make a number of choices, either explicitly or implicitly,4 which explains why different factor solutions typically lead to very different investment outcomes.5

Publicly available empirical studies that compare the factor exposures provided by ETFs with those provided by active mutual funds remain scarce.6 And the evidence reported so far is mixed. While the best mutual funds appear to provide higher factor exposure than comparable ETFs, a significant portion of the active factor products on offer clearly fails to deliver the expected level of factor exposure relative to cheaper ETFs.

The decision whether to opt for index-based or active strategies, in order to obtain the desired exposures to factor premiums, requires a careful and thorough cost-benefit assessment of all the options available. Every investor should make this assessment individually, naturally taking into account costs – including fees.

Now also follow us on Instagram
Now also follow us on Instagram
Follow

What should investors do about this? (the Robeco view)

So, while fees may be key for product selection, they must never be considered in isolation. Any potential fee reduction can very easily be wiped out by other elements, such as unintended negative exposures to proven factors, or simply due to arbitrage activity on public factor indices. Table 1 sums up four common pitfalls of generic strategies and the solutions active factor managers can offer.

Table 1: Pitfalls of a generic approach and possible solutions

Source: Robeco (January 2020)

In this context, well-designed active factor strategies can be worth the higher fees they entail relative to index-based products, as their enhanced approach have the potential to generate higher and smoother long-term outperformance. Yet periods of lagging performance relative to the market capitalization-weighted index remains inevitable, except for those investors successful enough to time their factor exposures. The debate over tactical factor timing will be addressed in the following article of this series.

1 See for example: Sharpe, W.F., 1991, ‘The Arithmetic of Active Management’, Financial Analysts Journal. See also: Bogle, J. C., 2014, ‘The Arithmetic of “All-In” Investment Expenses’, Financial Analysts Journal.
2 Blitz, D. C., Vidojevic, M., 2019, ‘The performance of Exchange-traded funds’, working paper.
3 See for example: Gushkov, D., 2016, ‘How Smart Are Smart Beta Exchange-Traded Funds? Analysis of Relative Performance and Factor Exposure’, Journal of Investment Consulting. See also: Blitz, D.C., 2016, ‘Factor Investing with Smart Beta Indices’, working paper. See also: Amenc, N., Goltz, F., Lodh, A., and Luyten, B., 2018, ‘Measuring factor exposure better to manage factor allocation better”, Scientific Beta Publication.
4 For an extensive discussion, see for example: Israel, R., Jiang, S. and Ross, A., 2017, ‘Craftsmanship alpha: An application to style investing’, The Journal of Portfolio Management.
5 For an illustration, see Van Gelderen, E. and Huij, J., 2014, ‘Academic knowledge dissemination in the mutual fund Industry: can mutual funds successfully adopt factor investing strategies?’, The Journal of Portfolio Management.
6 See, for example, Rabener, N., 2018, ‘Factor exposure: smart beta ETFs vs. mutual funds’, factor research note.

Important information

The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.

Subjects related to this article are:
Logo

Disclaimers

1. General
Please read this information carefully.

This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.

2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:

  • Some Funds are subject to investment, market, equities, liquidity, counterparty, securities lending and foreign currency risk and risk associated with investments in small and/or mid-capped companies.
  • Some Funds are subject to the risks of investing in emerging markets which include political, economic, legal, regulatory, market, settlement, execution, counterparty and currency risks.
  • Some Funds may invest in China A shares directly through the Qualified Foreign Institutional Investor (“QFII”) scheme and / or RMB Qualified Foreign Institutional Investor (“RQFII”) scheme and / or Stock Connect programmes which may entail additional clearing and settlement, regulatory, operational, counterparty and liquidity risk.
  • For distributing share classes, some Funds may pay out dividend distributions out of capital. Where distributions are paid out of capital, this amounts to a return or withdrawal of part of your original investment or capital gains attributable to that and may result in an immediate decrease in the net asset value of shares.
  • Some Funds’ investments maybe concentrated in one region / one country / one sector / around one theme and therefore the value of the Fund may be more volatile and may be subject to concentration risk.
  • The risk exists that the quantitative techniques used by some Funds may not work and the Funds’ value may be adversely affected.
  • In addition to investment, market, liquidity, counterparty, securities lending, (reverse) repurchase agreements and foreign currency risk, some Funds are subject to risk associated with fixed income investments like credit risk, interest rate risk, convertible bonds risk, ABS risk and the risk of investments in non-investment grade or unrated securities and the risk of investments made in non-investment grade sovereign securities.
  • Some Funds can use derivatives extensively. Robeco Global Consumer Trends Equities can use derivatives for hedging and efficient portfolio management. Derivatives exposure may involve higher counterparty, liquidity and valuation risks. In adverse situations, the Funds may suffer significant losses (even a total loss of the Funds’ assets) from its derivative usage.
  • Robeco European High Yield Bonds is subject to Eurozone risk.
  • Investors may suffer substantial losses of their investments in the Funds. Investor should not invest in the Funds solely based on the information provided in this document and should read the offering documents (including potential risks involved) for details.

3. Local legal and sales restrictions
The Website is to be accessed by “professional investors” only (as defined in the Securities and Futures Ordinance (Cap.571) and/or the Securities and Futures (Professional Investors) Rules (Cap.571D) under the laws of Hong Kong). The Website is not directed at any person in any jurisdiction where (by reason of that person’s nationality, residence or otherwise) the publication or availability of the Website is prohibited. Persons in respect of whom such prohibitions apply or persons other than those specified above must not access this Website. Persons accessing the Website need to be aware that they are responsible themselves for the compliance with all local rules and regulations. By accessing this Website and any of its pages, you acknowledge your agreement with understanding of the following terms of use and legal information. If you do not agree to the terms and conditions below, do not access this Website or any pages thereof.

The information contained in the Website is being provided for information purposes.

Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.

4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.

5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.

6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.

7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.

8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.

9. Privacy
Robeco guarantees that the data of persons accessing the Website will be treated confidentially in accordance with prevailing data protection regulations. Such data will not be made available to third parties without the approval of the persons accessing the Website, unless Robeco is legally obliged to do so. Please find more details in our Privacy and Cookie Policy.

10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong. 

Please click the “I agree” button if you have read and understood this page and agree to the Disclaimers above and the collection and use of your personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy and Cookie Policy, including for the purpose of direct marketing of Robeco products or services. Otherwise, please click “I Disagree” to leave the website.

I Disagree